This blog is a commentary on contemporary business, politics, economics, society, and culture, based on the values of Reason, Rational Self-Interest, and Laissez-Faire Capitalism. Its intellectual foundations are Ayn Rand's philosophy of Objectivism and the theory of the Austrian and British Classical schools of economics as expressed in the writings of Mises, Böhm-Bawerk, Menger, Ricardo, Smith, James and John Stuart Mill, Bastiat, and Hazlitt, and in my own writings.

Monday, July 31, 2006

Wage Rates and Purchasing Power

An individual who earns more money per week is obviously in a position to spend more in buying consumers’ goods than is an individual who earns less money per week. For example, a man who makes $1,000 per week has the ability to spend $1,000 per week, while a man who makes only $900 per week has the ability to spend only $900 per week. (For the sake of simplicity, we’re ignoring such possibilities as going into debt or using up savings, and assuming that the individuals both want to live within their incomes.)

When there is unemployment and free-market economists urge the freedom of wage rates to fall as the means of eliminating the unemployment, many people think of examples like the above and conclude that the free-market solution would only serve to make matters worse. They reason, in effect, that now workers who had been earning $1,000 per week would only earn $900 per week and thus be reduced to spending only $900 per week instead of $1,000 per week. Generalizing from this example to wage reductions of any size, and to their effect across the whole economic system, people conclude that wage-rate reductions cause reductions in overall consumer spending and therefore must serve to make the problem of unemployment worse, rather than better. In fact, often going under the name of Keynesianism, this is far and away the prevailing doctrine on the subject and is why reductions in wage rates are rarely if ever advocated as the means of reducing unemployment in the present-day world.

However, let us approach matters now not from the perspective of an individual wage earner, but from that of the economic system as a whole, essentially just like Henry Hazlitt did in his brilliant Economics In One Lesson.

In the economic system as a whole, in any given year, there’s a certain overall total amount of payroll expenditures by business firms, i.e., a certain overall total amount of wage payments. There’s also a certain overall total amount of consumer spending that takes place in the year. Since it‘s always essential to think in terms of numbers when dealing with such matters, let’s assume that in the economic system as a whole in a given year total payroll expenditures amount to 400 units of money. (This is certainly a very small number of units, but each unit can be understood as representing as many billions or tens of billions of dollars as may be necessary for the 400 units to represent the actual total payrolls of the present-day United States. Thinking in terms of a small number of units allows us to avoid wasting valuable brain space in holding strings of unnecessary zeros in our minds)

Let’s also assume that total annual spending to buy consumers goods in this economic system is 500 units of money, with each unit of money representing as many billions or tens of billions of dollars as does each of the 400 units of money paid as wages.

So here we are: 400 units of money is total wage payments and 500 units of money is total consumer spending in our hypothetical economic system.

We can assume that 400 of the 500 of consumer spending represents consumption expenditure by wage earners, out of their 400 of wage incomes. The remaining 100 of consumer spending can be taken as representing consumption by businessmen and capitalists, out of profits, interest, and dividends, and/or out of previously accumulated capital.

Now imagine that in this hypothetical economic system, there is 10 percent unemployment. That means that there is also 90 percent, positive employment. Going from 10 percent unemployment to full employment means increasing positive employment in the ratio of 10 to 9.

Isn’t it clear that if total payroll spending were maintained, a 10 percent reduction in wage rates would secure full employment? That it would mean 10/9 the workers employed at 9/10 the average wage. Wouldn’t consumer spending also hold up in these circumstances, with 10/9 the workers spending 9/10 the average wage per worker?

And if the output per worker remained the same, wouldn’t the same total consumer spending of 500 units of money be sufficient to buy 10/9 the output at 9/10 the prices? And wouldn’t total profit in the economic system, and, by implication, the average rate of profit, be the same, despite the fall in prices? (Wouldn’t total profit essentially continue to be 500 units of money in the form of consumption expenditure minus 400 units of money in the form of wage payments?)

What of real wages? If prices and wage rates both fall to the same extent, wouldn’t real wage rates be the same? In fact, wouldn’t real take-home wage rates actually increase because of the elimination of the burden of supporting the unemployed, who would now be employed and supporting themselves?

And notice the implication for how real wage rates can continually be further increased, namely, simply by virtue of labor becoming more and more productive and thus progressively increasing the supply of consumers’ goods relative to the supply of labor, thereby more and more reducing prices relative to wage rates.

This example, of 400 of wage payments and 500 of consumer spending, is a depiction of the economic world in terms of essentials. Mises would call it an imaginary construction. It is very highly simplified. Yet it is also extremely pregnant with implications: for employment/unemployment, for real wages, for profit/interest, and for much else besides.

Whoever starts to think about this example will have many questions, the answers to which obviously cannot be fitted into a brief article such as this. The questions can concern such things as the effects of adding the buying and selling of capital goods into the example, the effects of allowing for changes in the amount of spending in the economic system and for changes in the relationship between different kinds of spending, and more. For answers to all such questions, I invite those interested to read my book Capitalism: A Treatise on Economics. There I think they will find not only just about all of the answers they are looking for, but also many questions they have not thought of asking, along with the answers to those questions as well.